The risks of tailoring credit default swaps

Credit portfolio managers could tailor credit default swap hedges as financial guarantees to avoid accounting mismatches on their balance sheet. However, the technique exposes credit hedgers to increased costs and basis risk, argues Dirk Schubert

Credit default swap (CDS) contracts are frequently used by portfolio managers to hedge against default risk. International Accounting Standard (IAS) 39 requires these instruments to be measured at fair value, unless hedge accounting is applied in order to avoid volatility in profit and loss (Risk February 2009, pages 78–81). One alternative is to tailor the terms of the CDS contract so it meets the criteria for financial guarantee accounting under IAS 39. However, these rules are restrictive and